1 Firms, Production, and Costs

Production and time horizons

Firms combine inputs such as labor, buildings, equipment, and materials to produce goods or services. Their production and cost conditions shape the methods they use, the quantity they produce, and whether operating is profitable. The same production-and-cost framework applies in competitive markets and monopoly; market structure affects the revenue a firm earns from selling additional output.

A Production function describes the greatest output a firm can produce from given quantities of inputs using its available technology. In the Short run, at least one input is fixed; for example, a bakery may have a fixed number of ovens while hiring more workers. In the Long run, the firm can vary all inputs, including its facilities and equipment. These terms refer to how flexible inputs are, not to a particular number of days or years.

Productivity and diminishing returns

The Marginal product of an input is the additional output produced by using one more unit of that input, holding other inputs fixed. When a fixed input becomes crowded, marginal product may eventually decline. For example, adding workers who must share the same ovens can make each additional worker contribute less output.

This pattern is the Law of diminishing marginal returns. It helps explain why producing successive units can become more costly.

Costs and profit measures

A firm's costs include direct payments and the value of opportunities it gives up. Explicit costs are direct payments such as wages and rent. Implicit costs are the opportunity costs of resources the firm already owns, such as income an owner could have earned in another job.

Accounting profit subtracts explicit costs from revenue, while Economic profit subtracts both explicit and implicit costs. A firm can report positive accounting profit while earning zero economic profit: its resources are covering their opportunity costs, including the owner's normal return.

Short-run cost categories

In the short run, costs are commonly divided into fixed and variable costs. Fixed cost does not change with current output, such as a lease payment due during the production period. Variable cost changes as output changes, such as spending on ingredients or production labor. Total cost is the sum of these costs:

A fixed cost is not automatically a Sunk cost. A cost is sunk only when it cannot be recovered or avoided. For a short-run decision about whether to produce, an unavoidable fixed cost has already been incurred or must be paid either way. The firm therefore compares revenue with the variable costs it can avoid by shutting down.

Per-unit and marginal costs

Average cost measures express costs per unit of output. Average total cost and average variable cost are:

Marginal cost is the additional cost of producing more output:

Because fixed cost does not change with output in the short run, the change in total cost equals the change in variable cost. Average total cost includes average fixed cost and average variable cost:

When marginal cost is below an average cost, it pulls that average down; when marginal cost is above it, it pulls the average up. Accordingly, in the standard cost-curve model, marginal cost crosses average variable cost and average total cost at their minimum points.

Long-run costs and scale

In the long run, all inputs can be adjusted. A firm can choose among production methods and facility sizes to produce at the lowest feasible cost. Long-run average cost changes with output in three ways:

• Economies of scale occur when long-run average cost falls as output expands.

• Constant returns to scale occur when long-run average cost stays about the same as output expands.

• Diseconomies of scale occur when long-run average cost rises as output expands.

Choosing output to maximize profit

Profit equals total revenue minus total cost:

A firm can increase profit by producing another unit whenever the additional revenue from that unit exceeds its additional cost. It should reduce output when the additional cost exceeds the additional revenue. For an interior profit-maximizing output, the general rule is:

For this equality to identify a maximum, marginal cost should be rising through marginal revenue, not falling through it.

Market structure and marginal revenue

How revenue changes with output depends on market structure.

• Perfect competition: A perfectly competitive firm takes the market price as given. Each additional unit sold adds that price to revenue, so $\mathrm{MR} = P$. Its output rule is $P = \mathrm{MR} = \mathrm{MC}$.

• Monopoly: A monopolist faces the market demand curve. To sell more, it generally must lower the price, including on units it could otherwise have sold at a higher price. Therefore, marginal revenue is below price. The monopolist chooses output where $\mathrm{MR} = \mathrm{MC}$, then uses demand to determine the price buyers will pay for that output.

For example, suppose a competitive bakery can sell each loaf for $\$12$. If producing another loaf costs $\$9$, that loaf adds $\$3$ to profit, so increasing output is worthwhile. If marginal cost rises to $\$13$, producing that additional loaf reduces profit. The bakery should choose output near the point where marginal cost rises to $\$12$. If average total cost at that output is $\$9$, profit per loaf is $\$3$; total profit is that margin multiplied by the number of loaves sold.

Profit, loss, shutdown, and exit

At the chosen output, comparing price with average total cost indicates a perfectly competitive firm's short-run result:

• If $P > \mathrm{ATC}$, the firm earns positive economic profit.

• If $P = \mathrm{ATC}$, the firm breaks even economically, earning zero economic profit.

• If $\mathrm{AVC} < P < \mathrm{ATC}$, the firm incurs a loss but covers variable costs and some fixed costs. Producing can limit its loss compared with shutting down immediately.

• If $P < \mathrm{AVC}$, revenue does not cover variable costs. The firm minimizes its short-run loss by shutting down production, while still bearing unavoidable fixed costs. At $P = \mathrm{AVC}$, it is indifferent between producing and shutting down under the basic model.

A Shutdown is temporary and differs from Exit. In the long run, a firm can adjust all inputs and leave the industry. The decision to exit depends on whether it expects revenue to cover its avoidable long-run costs.